The archived blog of the Project On Government Oversight (POGO).

Apr 14, 2011

New Reports Put Financial Regulators in the Hot Seat

By Michael Smallberg

In case you missed it in our Morning Smoke, we wanted to highlight two must-read stories that came out today on the key causes of the financial crisis and the alarming absence of criminal prosecutions for the major players who drove the economy to the brink of collapse.

The lack of criminal referrals by our nation’s top regulators, widely observed by financial commentators and legal experts, is thoroughly documented in TRAC’s data:

The university’s Transactional Records Access Clearinghouse indicates that in 1995, bank regulators referred 1,837 cases to the Justice Department. In 2006, that number had fallen to 75. In the four subsequent years, a period encompassing the worst of the crisis, an average of only 72 a year have been referred for criminal prosecution....

Law enforcement officials say financial case referrals began declining under President Clinton as his administration shifted its focus to health care fraud. The trend continued in the Bush administration, except for a spike in prosecutions for Enron, WorldCom, Tyco and others for accounting fraud.

The Office of Thrift Supervision was in a particularly good position to help guide possible prosecutions. From the summer of 2007 to the end of 2008, O.T.S.-overseen banks with $355 billion in assets failed.

The thrift supervisor, however, has not referred a single case to the Justice Department since 2000, the Syracuse data show. The Office of the Comptroller of the Currency, a unit of the Treasury Department, has referred only three in the last decade.

This drop in criminal referrals is particularly striking compared to the surge in enforcement activity following the savings and loan crisis:

The cast of characters who have recently evaded criminal prosecution includes some of the most recognizable figures from the financial crisis: Merrill Lynch, Angelo Mozilo and Countrywide Financial, Lehman Brothers, Bear Stearns, Joseph Cassano and AIG-Financial Products, and more.

So why has the federal government taken such a light approach toward prosecuting the most notorious figures from the financial crisis? The Times article provides a few clues. There was the decision by the FBI in 2008 to scale back a plan to assign more agents to investigate mortgage fraud, and the subsequent decision by the Department of Justice (DOJ) to decline creating a task force dedicated to mortgage fraud investigations. There were also the officials at front-line regulatory agencies such as the Office of Thrift Supervision who failed to keep up with the increasingly complex and large-scale fraud perpetrated by the firms they oversaw.

Meanwhile, the government’s track record on the civil front has also been less than impressive. The Times makes several references to a 2009 policy at the Securities and Exchange Commission (SEC), developed in coordination with other financial regulators, that appeared to discourage aggressive enforcement action against banks that had received taxpayer funds through the bailout:

Four people briefed on the discussions, who spoke anonymously because they were not authorized to speak publicly, said that in early 2009, the S.E.C. created a broad policy involving settlements with companies that had received taxpayer assistance. In discussions with the Treasury Department, the agency’s division of enforcement devised a guideline stating that the financial health of those banks should be taken into account when the agency negotiated settlements with them.

The Times piece is the latest in a series of stories that have raised troubling questions about the government’s prosecution and enforcement activities in the aftermath of the crisis.

In December, POGO wrote about a case in which SEC lawyers accused the former head of one of the world’s largest hedge funds of paying a $2.1 million “hush money” payment to an insider trading tipster. We questioned why the SEC was only pursuing the case in an administrative setting, despite a clear fact pattern pointing to criminal misconduct. At a hearing the following month, Senate Judiciary Committee Ranking Member Charles Grassley (R-IA) questioned why DOJ has not brought any criminal charges related to the case: “If the Justice Department fails to act in a case where the government finds a hedge fund paid hush money to someone to get them to withhold crucial information, doesn’t this send the message that perjury to the SEC will be tolerated?”

Senator Grassley has also demanded answers on how the SEC coordinates with DOJ on securities fraud cases, after it was revealed that SEC Enforcement Director Robert Khuzami suggested to attendees at a financial law enforcement conference that the SEC will disclose information on possible DOJ criminal prosecutions to attorneys representing the target of a potential investigation: “We are going to try to get those individuals answers whether or not there is criminal interest in the case so defense counsel can have as much information as possible.” His remarks were revealed in Matt Taibbi’s blockbuster Rolling Stone piece exploring why no major figures from Wall Street have gone to jail.

The report includes several case studies to highlight what the Subcommittee considers to be the four key causes of the financial crisis: high-risk lending (e.g., Washington Mutual Bank) regulatory failures (e.g., the Office of Thrift Supervision), inflated credit ratings (e.g., Moody’s and Standard & Poor’s), and investment bank abuses (e.g., Goldman Sachs and Deutsche Bank):

Together these factors produced a mortgage market saturated with high risk, poor quality mortgages and securities that, when they began incurring losses, caused financial institutions around the world to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith in U.S. capital markets.

The Financial Times reports that Subcommittee Chairman Carl Levin (D-MI), who concluded that Goldman Sachs “clearly misled their clients and they misled Congress,” will be referring evidence of abusive practices by Goldman and other banks to DOJ for possible criminal prosecutions. This is a significant development, and we commend the Subcommittee for its hard-hitting bipartisan investigation. But as today’s New York Times story makes clear, there are still many obstacles to overcome before any major Wall Street figures face jail time for their misconduct leading up to the financial crisis.